Israel economy: Israel's technology sector faces challenges

Israel enjoys a reputation as a global centre for high technology and innovation. Not only is it home to a thriving industry of start-up companies, but it is also the world's top spender on research and development (R&D) on a per capita basis and hosts hundreds of multinational R&D centres. It has been a world leader in technologies as wide-ranging as automotive technology, cybersecurity, drones and agriculture. However, Israel's innovative capacity is built on a narrow base of human capital, and even that is showing worrying signs of deterioration due to a combination of uneven educational provision and changing demographics.

Israel spent 4.25% of GDP on R&D in 2016—more than any other country in the world and 1.9 percentage points higher than the OECD average. Close to half of that is spent at the more than 300 multinational R&D centres based in the country. In terms of triadic patents (patents filed in the EU, the US and Japan, the most important patent centres), Israel registered 51.3 per million population, ranking ninth in the OECD and scoring above the 40.3 average for OECD countries. In The Economist Intelligence Unit's Business Environment Rankings, Israel ranks 18th globally (out of 82 countries) and first in the Middle East and Africa region for technological readiness (which also looks at the consumer market).

The 2017 Global Innovation Index collated by INSEAD, a France-based business school, ranks Israel's main commercial city, Tel Aviv, 22nd and another city that is home to Israel's best-known technical university, Haifa, 78th in the world, based on patents taken out via the Patent Co‑operation Treaty. High-technology manufacturing exports accounted for nearly half (47%) of all Israeli industrial exports in 2017, mostly in the form of electronic components and pharmaceuticals. Exports of high-tech services have boomed in recent years (largely due to the export of services from the multinational R&D centres) and exceeded exports of high-tech goods for the first time last year.

Education has played a key role, but shortcomings remain

Israelis are well educated by international standards: in 2016 50% of the adult population aged 25-64 had a tertiary degree, 13 percentage points above the OECD average and ranking fourth among the 35-member group. Israeli universities rank relatively well by global measures; five are among the top 500 measured by the Shanghai Academic Ranking of World Universities. In science, the Technion-Israel Institute of Technology (based in Haifa) ranks 44th, and in engineering both the Technion and the University of Tel Aviv are in the 51st-75th range.

However, the quality of education at the primary and secondary levels has become an increasing source of concern in recent years. Although education spending has doubled over the past decade, the Quality of Education Index compiled by the Bank of Israel (the central bank), which examines a broad range of cognitive skills, rates Israel at 4.7, below the median of 5.0 and the seventh-lowest score among OECD countries. The scores of Israeli students taking the international PISA examination of science, mathematics and reading skills have risen since 2006, but they remain far below the average for OECD countries; Israel ranked 29th among 35 countries in science and reading and 27th in mathematics according to the 2015 results (the latest available). Although school-age Israelis are more likely on average to use computers and the internet than their OECD peers, they are less likely to use them in school, where only 55.2% of students reporting using them, versus 72% of all students on average in the OECD.

Furthermore, Israeli students' low test scores understate the problem because of the growing population of ultra-Orthodox Jewish students, who are educated in a different system and do not participate in the testing. Their education often lacks any more than a modicum of secular studies, including mathematics and science. Only a tiny minority study for a tertiary degree. The Bank of Israel found that ultra-Orthodox schooling left a graduate with the job-performance abilities of someone with a 10th-grade education. A government study has predicted that unless there is a significant change in the ultra-Orthodox attitude toward secular education, the increase in the average level of schooling in Israel will come to a standstill around 2039, and by 2059 Israel will be 26th in the OECD for average education, ten places below its current level.

For many, the shortcomings in the educational system are subsequently made up for by the army, in which the great majority of non-ultra-Orthodox Israelis serve. This is especially the case for those recruited to elite technology units, most notably the 8200 intelligence unit, the alumni of which are responsible for many of the innovative achievements of Israel's technology sector and start-up entrepreneurship. Overall, however, Israeli workers lag behind most of their peers in tests of literacy, numeracy and problem-solving, even though Israelis on average have more years of schooling than other countries, according to the OECD's Programme of International Assessment of Adult Competencies. Israeli companies outside the technology sector often trail their developed-country peers in employing technology or the most advanced management practices.

Companies have struggled to reach maturity in Israel without external support

Israel's high-tech industry is dominated by start-ups, few of which mature into large businesses; start-up performance is therefore often used as a measure of the country's prowess in technology. In financial terms the industry is thriving, with companies raising a record US$5.24bn in 2017, nearly three times the level five years earlier, according to the Tel Aviv-based IVC Research Centre. On the exit side, figures from PwC Israel show that the total value of merger-and-acquisition deals and initial public offerings soared to US$23.8bn. However, these figures belie worrying trends. The number of new start-ups declined sharply in 2016 (the latest year for which official figures are available) to 625, from 750, in the first drop in many years, while the number that closed jumped by 30% to 396. Over the last decade the technology sector's share of total Israeli employment has remained stagnant at around 8%.

Among other things, this may reflect a tightening supply of talent in engineering and other fields, which is manifesting itself in rising salaries for skilled professionals. Figures from Ethosia, an Israeli recruitment firm specialising in technology jobs, show that the average monthly salary for hardware and software engineers with two years' experience or less rose by 20% in 2017. The percentage of Israeli graduates in science, mathematics and engineering declined slightly to 29.4% of the total over the 15 years to 2015. In mathematics and computer science that level fell more sharply to 6.7% of all graduates, from 8.3%. The government's Israel Innovation Authority forecasts a shortage of 10,000 engineers and programmers over the next decade—a serious shortfall in a market that employs 140,000.

The Israel Innovation Authority is embarking on a ten-year programme to double the number of technology workers and is easing the way for companies to bring in overseas talent, but the impact will not be felt for some time. Meanwhile, technology companies are relying more on outsourcing abroad. In recent years the government has taken some measures to ease restrictions on immigration and work permits for skilled workers in the sector. If US tax reforms to reduce corporate taxation encourage US multinationals to bring jobs home, as some in Israel fear, many of the R&D centres in Israel may lay off staff and help to ease the labour supply shortage in the short term, although the level of specialised knowledge in Israel may provide some protection. Moreover, if Israel wants to maintain a leading global position and sustain export growth, it will need to ensure that its labour force remains up to the task.